Theme 4B - Inequity

Government Intervention

State aims of GI

1. Achieve a more equitable distribution of output (by influencing the prices of certain goods and services)

2. Address the problem at its root by intervening in labour markets to create a more equal distribution of income

State

Measures to influence the price of necessities

Measures to influence the income levels of low-income households

Redistributive measures

Measures to influence the price of necessities	Measures to influence the income levels of low-income households	Redistributive measures
Price ceiling  Price floor  Production subsidy  Promotion of R&D for innovation	Wage controls  Transfer payments  Skills upgrading	Production tax  Income tax  Wealth tax

Describe price controls

• Governments are artificially setting a price different from the market clearing price (the equilibrium price)

• These controls can take the form of stipulating a maximum price (price ceiling) or a minimum price (price floor)

• Aim : reduce large fluctuations in prices and prevent extreme prices for certain essential goods, such as water and agricultural products, in the interest of consumers and producers

Define price ceilings and why it is implemented

• (Def.): maximum permissible price that producers may legally charge for a particular good or service

Reasons : 

1. To keep the price of a good at a level affordable to the majority, in order to protect consumers’ interest (Eg. Healthcare and rent)

2. To prevent exploitation by producers who may charge high prices in times of shortages (Eg. Rice during war times, or surgical masks during a virus outbreak)

For the maximum price regulation to be effective, the price must be set below the market equilibrium price

Draw and describe price ceiling graph

• In a free market economy, price should increase when there is a shortage

• However, with the price ceiling in place, sellers cannot sell above this price (Pc) -> persistent shortage 

• Hence the shortage cannot be eliminated and only Qs is traded in the market

Describe impact of price ceiling on CS

Initially consumer surplus = area aePE With the maximum price, the new consumer surplus = area auwPMAX Consumers are able to obtain the good at the lower price benefit However, there will be some consumers who are no longer able to obtain the good since the quantity purchased drops from QE to QS Hence, change in consumer surplus depends on the relative sizes of area ued and area PEdwPMAX

Describe impact of price ceiling on PS

• Initially, producer surplus = area PEce

• With the maximum price, the new producer surplus = area PMAXwc

• There is a loss in producer surplus of area PEewPMAX

Describe positive impacts of a price ceiling

1. Relative ease of implementation 

• A maximum price can be implemented quickly when needed and effects are almost immediate -> can be viable in the short term, particularly when the economy is faced with extraordinary circumstances (Eg. war, volatile agricultural prices)

2. Relatively less costly 

• A maximum price is cost-effective since there is little cost incurred by the government apart from monitoring costs and administrative costs associated with implementing rationing to allocate the goods

State negative impacts of price ceiling

1. Welfare loss

2. Some consumers lose out due to shortages 

3. Emergence of black markets 

4. Not addressing the root cause

Describe welfare loss caused by price ceiling

• When a maximum price is imposed, it obscures price signals that normally guide the allocation of society’s resources to the socially optimal level of output -> welfare loss to society

• A price ceiling of PMAX imposed creates a shortage of QSQD units -> quantity sold drops from QE to QS

• The quantity sold is now less than the socially optimal level at QE -> causes a welfare loss equal to area uew (TSB > TSC)

Describe Some consumers lose out due to shortages due to price ceiling + graph

• An alternative allocation mechanism is required -> 1st come 1st serve -> rationing through coupons 

• Consumers who are unable to get the good lose out -> frustration with the shortages lead to social unrest 

• As supply becomes more price elastic overtime -> producers will respond by reducing Qs more -> shortage worsens in long run (initial shortage of QSQD, shortage rises to Q0QD) 

Describe emergence of black market caused by price ceiling

• A black market is one where sellers ignore the government’s price restrictions and sells the good at illegally high prices above legal price ceiling 

• Objective of policy not achieved 

• The shortage may also mean some desperate consumers suffer from inequitable access to necessities and need to obtain the product through the black market

• Only high-income households can afford the goods sold in the black market

• In countries with weak legislative framework -> maximum price difficult to enforce 

Describe not addressing root cause caused by price ceiling

• There may be a need to raise supply by improving productivity

• But if the maximum price is viewed as a quick-fix, such priorities may be neglected

Define and describe price floor

• (Def.): Minimum permissible price that producers may legally charge for a particular good or service

• Can be implemented by law or by government guaranteeing to buy up the good at a stipulated price

• Producers are prohibited from selling below the stipulated price, but prices can rise above it

• For a minimum price to be effective, it must be set at a price above the market equilibrium price

Draw price floor graph + describe

• Governments used a price floor to protect incomes of low income producers by raising producers’ revenue or by preventing their revenue from falling -> increase their revenue -> reducing inequality as producers can afford basic necessities 

• Cause a persistent surplus of QSQD

Explain welfare effects when:

By legislation (government does not buy surplus)

By government guaranteeing a minimum price and buying up surplus

By legislation (government does not buy surplus)

By government guaranteeing a minimum price and buying up surplus

Quantity demanded falls to QD -> CS is lowered from aePE to ajPMIN Assuming perfect information, producers would reduce their quantity supplied accordingly to QD lower than socially optimal level, as producing any more than QD would result in a surplus -> require producers to incur storage costs or wastage  PS changes from bePE to bkjPMIN There is welfare loss of area jek

The quantity supplied will then increase to Qs units while quantity demanded falls to QD units, creating a surplus at PMIN, which the government has committed to buy up CS is lowered from aePE to ajPMIN PS changes from bePE to bmPMIN Sum of CS and PS increase by jme  This increase in CS+PS of area jme came at a cost to society in the form of the government having to incur spending of QDjmQS in order to buy up the surplus of QSQD at the price of PMIN Subtracting the loss from the gain, the society has incurred a net welfare loss of the M-shaped area (QDjemQS) due to allocative inefficiency caused by misallocation of resources Producers are the beneficiaries of government-supported price floors while the consumers are forced to buy less and to pay more than they would otherwise TR = Consumers TE + government spending = minjQd0 + jmQsQd

Describe positive impacts of price floor

1. Might enable a government to incur lower costs compared to giving a subsidy to producers

• This is applicable when a minimum price policy is used specifically to tackle periods when prices are exceptionally low

• Even if government has to buy surplus, once prices recover and equilibrium price is at or above the minimum price, the government will no longer incur an expenditure (no need to buy surplus) 

• More cost efficient than adopting subsidies which may be difficult to remove even when prices recover

Describe negative impacts of price floor

1. Welfare loss

• Welfare loss incurred if minimum price causes the market price and quantity to move away from the socially optimal level

• Wastage of society’s scarce resources is heightened if the surplus is disposed or destroyed subsequently, especially for perishable goods such as fruits and vegetables

2. Dynamic and productive inefficiency 

• Firms might become complacent and lack the incentive to engage in innovation or improve their production methods to lower costs

• If firms can be guaranteed to sell their product at the higher price floor level -> less pressure to minimise the cost of production available -> productive inefficiency 

3. Consumers lose 

• A minimum price policy benefits producer -> loss in CS 

4. Inequity of distribution worsen 

• Consumers face higher prices -> lowers their ability to consume goods and services

5. Expensive for government 

• Government incurs expenditure to buy excess stock 

• Government incurs additional expenditure to store the surplus stock -> opportunity cost 

• If the higher government expenditure is financed via higher taxes -> added burden on taxpayers -> rendering this policy fiscally unsustainable in the long run